ETF Liquidity Tiers in Dec 2009

Quantifying liquidity can be difficult, especially for ETFs.  For stocks, it is typically a function of the ADVT (average daily value traded, sometimes called dollar-volume) and the number of shares outstanding.  The same approach cannot be applied to ETFs because the number of shares outstanding is subject to change at any time.

Unlike stocks, ETFs have a creation/redemption process that allows the addition of new shares to meet increased demand.  Likewise, ETF shares can be retired (redeemed) when demand wanes.  This feature increases ETF liquidity far beyond the level of stocks with similar trading volume.  The full extent of that increase is subject to debate.

While the creation/redemption process is a significant factor for ETF liquidity, there are other factors as well.  For example, the bid/ask spread of the underlying stocks and whether or not the stock exchange of the underlying stock is open can have a huge impact on liquidity.  Additionally, with more than 900 ETFs, market makers can’t keep up with them all, and many with lower volume get ignored.

Although it is not an all-encompassing approach to measuring liquidity, using ADVT to divide ETFs into liquidity tiers is a reasonable way to gauge ETF relative liquidity.  ETFs with an ADVT of less than $1,000 dollars (yes, there is such a group) comprise Tier 1.  At the other extreme is Tier 9, ETFs that trade more than $10 billion per day.  Each intervening tier represents an order of magnitude increase from the previous level.

These liquidity tiers apply only to ETFs for comparison to other ETFs.  It is not appropriate to compare ETFs to stocks using the same scale because of the differences in liquidity factors described above.

The graphic that accompanies this article shows each liquidity tier, along with the number of ETFs that make up a particular tier.  The information is derived from December 2009 trading data which has reduced volume due to the holidays.

Tiers 1, 2, and 3 are those with an ADVT of less than $100,000.  ETFs in these tiers often have days with zero volume and are included in my ETF Deathwatch if they are more than six months old.  These three tiers represent about 16% of the ETFs.

The largest is Tier 4 – ETFs trading between $100,000 and $1 million per day.  About 35% of the ETFs fall into this category.  Trading levels in this tier are often spotty, sometimes with only a handful of trades per day.  Traders should generally avoid these ETFs while investors should use limit orders.  When combined, Tiers 1-4 represent the majority (>51%) of ETFs, which is another way of saying that most ETFs have liquidity concerns.

Tiers 5, 6, and 7 represent increasing volume and value traded.  The bid/ask spreads are supported by deeper volume, and market makers are usually keeping an eye on trading price versus indicative value.  Depending on the size of your trades, market orders start to become a possibility for the 443 ETFs in these tiers.

Tiers 8 and 9 represent the best of the ETF world in terms of liquidity.  These are the members of the ETF Billion Dollar Club – the ETFs that garner the lion’s share of ETF trading.  There are typically about 16 ETFs in this category, fewer than 2% of all U.S. listed ETFs, but in December that number fell to just eight.

The combination of Tiers 7 – 9, all ETFs with an ADVT above $100 million, is a fairly close representation of the Vital Few – the 8% of ETFs that are responsible for 92% of ETF trading activity.

Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.